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If you invest in gold, you will probably have heard of investing in gold mining stocks. These gold mining stocks generally offer higher returns when the price of gold rises, but the risks are also much higher. In this article, we'll explain why investing in gold mines is riskier and why Buy physical gold is a safer alternative.
The business model of a gold mine is to extract gold from the ground at a certain cost price and sell it back on the global gold market for a higher price. It acts as a lever on the Gold price, because the profit margin of a gold mine increases more than proportionally with an increase in the price of gold. If the price of the precious metal falls, the leverage works in the other direction. The profitability of a gold mine decreases more than the value of an investment in gold itself.
To illustrate the downside risk, we have compared the price development of gold and gold mining shares. The graph below shows the development of the gold price in yellow. The two blue lines refer to gold mining stocks. The light blue line is the price development of the VanEck Gold Miners ETF (GDX), a fund consisting of several large and well-known names in the gold mining sector. These are gold mines that are already producing in abundance and that are often active in several countries. The dark blue line is from the VanEck Junior Gold Miners ETF (GDXJ) and refers to mines that are often still in the exploration phase. These mines do not always produce gold, but they have, for example, mapped underground reserves.
Gold has outperformed gold mining stocks since 2010
As you can see, gold has delivered more returns than gold mining stocks over this period. With the rising gold price in the period of 2010 and 2011, the gold mining shares performed better, but when the price fell again after that, the mining shares fell much harder. In 2016, the gold price was back to the level of six years earlier, but the prices of gold mines were much lower. At the time, the loss was 70 to 80 percent compared to the prices in 2010. Thus, the downside risk of investing in gold mines is much greater than that of buying physical gold.
It should be noted that we did not include the dividend in this calculation, but in the relatively bad years for the gold market, it was usually less than one percent per year, both for GDX as for GDXJ. If we include the dividend in the calculation, the return of the gold mines is slightly higher, but not significantly higher. The physical precious metal was still the better investment, also due to the lower downside risk.
Of course, there are also periods when gold mining stocks do perform better. If we take the bottom in the gold market at the beginning of 2016 as a starting point, we see that gold mining stocks did perform better in this upward trend. While the gold price rose by about 85% during this period, the gold mining stocks in the basket of GDX and GDXJ increased in value by 167% and 182% respectively. That's a doubling of the return.
During this period, gold mines yielded a better result, but with a much higher risk. As the graph below shows, the price fluctuations of the gold mining shares were much larger than those of the gold price itself. At the beginning of the corona crisis, mining stocks lost about a third of their value in a short period of time, while the correction in gold was limited to less than ten percent. The high volatility makes gold mining stocks very interesting for speculators, but less suitable for savers who just want to sleep peacefully.
Gold mining stocks have performed better in recent years, but with more volatility
What is not immediately apparent from these charts is that gold mines have a much greater counterparty risk. For example, the government of a country can force a gold mine to cease production. It can also happen that a gold mine has to sell its gold to the central bank of the country. This is usually done at a less attractive rate or in the local currency, which reduces profitability. When the price of gold rises sharply, the government of a country may decide to designate the precious metal as a strategic asset. As a result, the precious metal is not allowed to leave the country. In addition, there are the normal business risks. Think of strikes and production problems, but also of environmental pollution or disappointing yields from a gold vein.
Buying gold is therefore not the same as investing in gold mining stocks. The value of both investments moves with the price of gold, but not in the same way. Physical gold is the more secure and stable investment of the two. So, this option is preferable if you are looking for an alternative to the savings account. Are you willing to take on more risk and are you not afraid of a little more volatility? Then shares of gold mines are an interesting addition to your investment portfolio. Then preferably choose gold mines in countries with a stable political and economic climate. In a rising market, gold mines perform better, but due to the counterparty risk, it is a supplement to rather than an alternative to buying physical gold.
This contribution comes from Geotrendlines
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